THE EFFECTS OF ECONOMIC REFORMS ON MANUFACTURING DUALISM: EVIDENCE FROM INDIA

1. THE EFFECTS OF ECONOMIC REFORMS ON MANUFACTURING DUALISM: EVIDENCE FROM INDIA Vinish Kathuria IIT Bombay (Rajesh Raj S N CMDR Dharwad Kunal Sen University of Manchester) PROJECT FUNDED by Economic and Social Research Council, UK ESDS Conference Nov 28 2011

2. Introduction • Dualism in the organization of production activities is a permanent feature of developing countries, where a large informal sector coexists with a relatively small formal sector. • Despite strong economic growth, the persistence in the size of informal sector along with large differences in productivity between the formal and informal sectors has remained a matter of concern Economic reforms and manufacturing dualism

3. Objective…… • This paper examines the effects of economic reforms on manufacturing dualism • Dualism: differences in efficiency levels between informal and formal manufacturing firms • Considered absolute (AE) and relative technical efficiency (RE) • AE - extent to which firms in the manufacturing sector are producing the maximum possible output, for a given bundle of inputs, in a given industry (improvement in level) • RE - extent to which other firms are close to the most efficient firm in a given industry (improvement in equity) Economic reforms and manufacturing dualism

4. If dualism has reduced………. • Our objective is to investigate whether economic reforms have led to an increase in absolute technical efficiency and a decrease in RTE of informal firms relative to formal firms • Reforms would have reduced manufacturing dualism if absolute TE of informal firms have improved relative to formal firms while RTE has fallen • This implies that reforms would have had a positive effect on both the level and distribution of efficiency in the informal sector as compared to the formal sector, and therefore, would have strong pro-poor growth effects Economic reforms and manufacturing dualism

5. Present study……… • focuses on Indian manufacturing sector where • about 80 per cent of manufacturing employment and 17 per cent of manufacturing output is in the informal sector • we have large cross-sections of firm-level data-set for both the informal and formal manufacturing sectors for four years, beginning in 1989-90 and ending in 2005-06 Economic reforms and manufacturing dualism

6. 2. Methodology – Sample Selection Framework • We employ a method developed by Greene (2010) that corrects for self-selection bias to obtain firm level measure of absolute and relative technical efficiency • Theoretical models predict that firms choose whether to be in the informal or formal sector depending on factors which are mostly available to the formal sector (Dessy and Pallage 2003, Straub 2005, Ulyssea 2010) • Efficiency comparison needs to address the endogeneity of firm location • Else bias upwards the efficiency levels of formal firms if these levels depended on the firm being located in the formal sector. Economic reforms and manufacturing dualism

7. 3. Empirical Specification • First stage analysis • Firms choose between formal or informal sector subject to a set of variables that capture the benefits and costs of formalization • We estimate probit models of the following type: • F = αZi + wi • Where F is a dummy variable that takes the value 1 for formal sector firms and 0 for informal sector firms, • Z is a vector of variables explaining the decision to formalize, • α is a vector of parameters, and wi is the white noise error term Economic reforms and manufacturing dualism

8. 3. Empirical Specification • Drawing from the recent theoretical literature, we considered: • labour laws, • priority sector lending, • price of power supply and • firm size • as the variables that determine the benefits and costs of formalization in Indian manufacturing • Choice of these variables also exploit the fact that there are important differences in institutions relating to labour regulation, access to credit and the provision of infrastructure across Indian states and over time Economic reforms and manufacturing dualism

9. 3. Empirical Specification • Second stage analysis • We modelled the production behaviour of formal and informal sector firms using a simple Cobb-Douglas function as follows: • ln(QiT) = 0 + 1ln(KiT) + 2ln(LiT) + (viT - uiT) • Where T=1989-90, 1994-95, 2000-01 & 2005-06 and i is the firm. • Q is output, K is capital, L is labour, and s are parameters to be estimated • viT captures the random shocks that are beyond the control of firms • uiT represents technical inefficiency which is the combined outcome of non-price and organizational factors that constrains a firm from achieving their maximum possible output Economic reforms and manufacturing dualism

10. 3. Testing for Impact of Reforms on Duality • Effect of reforms on duality • an interaction term for our reform variable with that of the formal firms is introduced • TEijt = α + β1*FORMALijt + β2*REFORMSjt + β3*FORMALxREFORMSijt + δj +γt + εijt • If δTE/δFORMAL = β1 + β3*REFORMS < 0 •  reforms have reduced duality • We used estimates of absolute and relative technical efficiency alternately as our dependent variable Economic reforms and manufacturing dualism

11. 4. Data and Variables • ASI data for the formal sector and • NSSO data - surveys on the unorganized manufacturing sector for the informal sector • Unit level data for four years, 1989-90, 1994-95, 2000-01 and 2005-06; repeated cross-sections, and not in panel form • Confined the analysis to those informal firms that employ at least one hired worker • serious limitations of the data on output and capital stock for firms that employ only family labour • interest is in firms that are likely to modify their behaviour in response to policy changes as family firms in informal sector are often in business to bring in additional income with little additional effort and are unlikely to expand or invest in their businesses Economic reforms and manufacturing dualism

12. 4. Data and Variables –Reform Variables • Tariff: • trade and industrial output data of the World Bank Trade Data-base (World Bank 2006) • Delicensing : • Data on number of industries delicensed is obtained from Aghion et al (2006) and different notifications of GoI. • constructed as the total number of four-digit industries delicensed in a year to that of total number of four-digit industries in the sector • Dereservation: • list of number of products dereserved is obtained from different notifications of the GoI • constructed as the cumulative number of products dereserved in respective two-digit industries to that of total reserved products Economic reforms and manufacturing dualism

13. 4. Trend of Reform Variables • most of the delicensing reforms were over by 1995 • dereservation reforms started after 1995 • by 2005-06, only 4% of industries required delicensing, nearly one-third products needed to be dereserved and average tariff was 29% (ranging between 24% to 37%), much below 100% tariff around 1991 Economic reforms and manufacturing dualism

14. 5. Impact of Reforms on Duality Impact of reforms on duality of Indian manufacturing industry Economic reforms and manufacturing dualism

15. 5. Results • For the average values of REFORM variable, the efficiency difference between formal and informal firms is 0.04 for absolute efficiency and 5.35 for RTE. • At the mean value of absolute technical efficiency (0.44), this suggests that reforms have increased the efficiency of formal firms by 9 per cent vis-à-vis informal firms. • Similarly, relative to a mean RTE of 24.5%, the efficiency gap between the representative formal firm and the MEF in a particular industry has increased by 21.9% as compared to the efficiency gap between the representative informal firm and the MEF in the same industry. Economic reforms and manufacturing dualism

16. 5. Results – TE vs. Reforms REFORM vs efficiency relationship - stronger in the formal sector as compared to the informal sector Economic reforms and manufacturing dualism

17. 5. Results – RTE vs. Reforms REFORM vs efficiency relationship - stronger in the formal sector as compared to the informal sector 11/17/2014 17 Economic reforms and manufacturing dualism

18. 6. Conclusions • Do economic reforms reduce or exacerbate manufacturing dualism? • Our regression results suggest that these reforms have had an unambiguous positive effect on the absolute efficiency levels of formal firms relative to informal firms, and a negative effect on the relative efficiency levels Economic reforms and manufacturing dualism

19. 6. Conclusions • Economic reforms (as measured by individual reform variable or composite index) had an unequalising effect on the manufacturing sector, as it exacerbated the productivity differentials between average firm in the informal & formal sectors, and • at the same time, it reduced the gap in efficiency levels between formal firms as compared to informal firms •  Dualism has increased in Indian mfrg. after the reforms, both between formal and informal firms and within the informal sector Economic reforms and manufacturing dualism